Valuing Professional Service Firms – Part 2
The case of law firms: An adventure
Valuation of closely-held businesses is deceptively straight forward. It requires the discounting of future cash flows at an appropriate discount rate. Estimating future cash flows and selecting an appropriate discount rate are not easy, but they can usually be done. This process results in an estimate of what the valuation profession calls “fair market value”, i.e., the price a willing buyer would pay a willing seller, both being fully informed about the relevant facts of the case.
The big picture
Because of special regulatory circumstances, law firms are never valued the way other businesses (and other professional practices) are valued. Apart from the fact that a controlling interest in a law firm can only be owned by lawyers, law firms cannot be sold, except in certain special circumstances. PA Code Rule 1.17 Sale of Law Practice specifies that a law practice can only be sold if the selling lawyer retires at the moment of sale. The sale must be of the entire practice of the selling lawyer. Therefore, a lawyer cannot do what other professionals commonly do—sell their practices and continue working for several years for the new owner.
Also, it is considered unethical for a lawyer to sign a non-compete/non-solicitation agreement with the firm he or she is a partner in or employed by. Therefore, any lawyer can leave her employer and take all of her clients with her. So, even if it were permitted to purchase law firms like any other businesses, no one would want to buy one because there is nothing to prevent the law firms’ attorneys and clients from leaving the next day.
The reasoning behind these rules is helpfully explained in the PA Code as follows: “The practice of law is a profession, not merely a business. Clients are not commodities that can be purchased and sold at will.…”Therefore, unlike other “learned professions” such as medicine, architecture, engineering, and accounting, a law practice cannot be treated as a business. In the words of lawyer and law consultant Jerome Kowalski, “We have learned … that lawyers, trusted business advisers to the global markets, have concocted the silliest business model for their own firms … any other business owner can build a viable enterprise and then look forward to selling it or leaving it to the family … lawyers can do neither … the most they get on exit is a return of capital … a commercial law firm is worth nothing really because its most valuable assets—its working partners—are free agents, whose professional code of ethics prohibits covenants not to compete.”
The special cases
Although in general, a law practice cannot be treated as a business, and cannot be “valued” as other businesses and professional practices are, there are certain circumstances in which a law practice must have a value assigned to it. The first such circumstance is the one mentioned above—the case where a lawyer is retiring and sells her entire practice to another lawyer. The question here becomes what does the selling lawyer have that can be transferred to a buyer? Perhaps a customer list, but of course the customers must be informed that they have no obligation to continue with the purchasing lawyer. Sometimes there is ongoing litigation or other legal matters, and the selling lawyer can recommend to his clients that the purchasing attorney is best positioned to successfully prosecute these matters. Or perhaps the selling lawyer has “will files”—clients for whom the lawyer has written wills and other estate planning documents and has a reasonable expectation that he or she will settle the estate when the time comes. In almost all of these cases, the selling lawyer will receive a percentage of future revenues arising from these cases, which might range from 10%–50% depending on how lucrative these matters are.
The second special case is when a lawyer retires from a firm and the firm has a policy in place to purchase the retiring attorney’s interest in the firm. The “partners’ agreement” will specify the amount to be paid and the terms. This might range from the partner’s share of the book value of the firm (also referred to as a “return of capital”), to a multiple of the retiring partner’s annual earnings. This type of buy-out is wholly discretionary—there is no obligation for any law firm to pay anything to a retiring partner. The law firm might decide that it is a good practice to pay a buy-out so as to encourage the departing partner to keep his or her clients with the firm. Or this “retirement package” might just be part of the firm’s larger compensation package.
The third special case—the value of a law practice to the lawyer’s spouse in the event of divorce—is the most interesting. I suppose the divorce courts could have held that since the attorney’s spouse is not retiring and therefore cannot sell the practice, that it has no value. But the courts didn’t do that; they established various methods for determining value.
Courts have countenanced a number of ways of valuing a law practice for purposes of marital dissolution. One particularly controversial case was McCabe v. McCabe [525 PA 25 (1990), 575 A.2d 87]. In that case at the trial court a business valuation expert had determined that the fair market value of Mr. McCabe’s interest in a Philadelphia law partnership was $286,000. This analysis included McCabe’s share of the firm’s receivables. However, Mr. McCabe argued that the value for these purposes was limited to the amount he would receive at his retirement per the partnership agreement, $18,900, even though he was years away from retirement. The case went to the PA Supreme Court which held in a sharply divided 4–3 majority opinion that the proper value was $18,900. The dissenters objected “strenuously.” The dissent noted that a partner’s creditors under Pennsylvania law could reach the partner’s share of the partnership’s assets but under this ruling the partner’s wife could not, even though the partnership interest was a marital asset that the spouse had helped her husband obtain.
In a subsequent Pennsylvania Supreme Court case (Butler v. Butler, 541 Pa. 364 (1995) 663 A.2d 148) the same issue was presented as in McCabe, except here the value of an accounting firm was at stake. The majority opinion came to the opposite conclusion in Butler arguing that the shareholder’s agreement was not controlling. The Court attempted to distinguish the shareholders agreements in Butler and McCabe, but in Butler another vigorous dissent stated there was no clear distinction and McCabe should control.
Our conclusion from this and our experience as a valuation expert providing advice in similar cases is that the value of law firm interests for purposes of divorce remains a hotly contested matter.
Published in Business2Business magazine, July 2015